Speech
The Evolving Risk Environment

Thanks for the opportunity to speak to you today. I
have taken as my subject ‘the evolving risk environment’.

As you know, the Reserve Bank has a longstanding mandate
to promote financial stability. The way we interpret
that mandate, its place in the wider central banking
framework, and its interaction with the mandates of
the other financial regulators, are large topics in
themselves.[1]
For today, I simply note that one of the ways we seek
to promote financial stability is by providing regular
analysis of system risks, particularly through our half-yearly
Financial Stability Review. We do that partly
to inform the policy debate, but also because it is
important that lenders and investors are well informed
about the risk environment, so that they can make prudent
decisions about the risks they choose to accept.

As investors in the share market, you will be well aware
that investment is a risky activity. In the early part
of this year we have seen some significant falls in
equity prices and higher volatility in equity markets
around the world. There has been significant volatility
in other markets too, notably including large falls
in oil prices. There is no shortage of commentators
offering interpretations of these events and predictions
of what might follow.

I am not going to be offering those sorts of predictions
today. Instead, I think the way I can best contribute
to your thinking about these things is to place them
in the wider context of the evolving financial risk
environment over the past few years.

The post crisis environment

In many ways the current situation continues to be shaped
by the aftermath of the global financial crisis (GFC).
The epicentre of the crisis is usually dated to the
collapse of Lehman Brothers in September 2008, and the
general recovery that we have had since then began about
six months later. On that basis, we have been in a period
of global economic recovery now coming up to about seven
years.

In broad outline, this has been a period marked by:

A return to reasonably solid growth in world GDP, at
rates either around trend or not much less than that.

Widespread, though somewhat varied, progress in balance
sheet repair in banking institutions; and

Generally improved conditions in financial markets.

These have all been positive developments: they represent
a substantial cumulative improvement since the height
of the crisis, and it is important to keep that perspective
when interpreting shorter-term fluctuations in market
sentiment.

That said, there are a number of qualifications that
should be made to the summary picture I have just given:

Growth around the world during this period has been
uneven geographically. China and other emerging market
economies initially led the recovery while Europe tended
to lag. More recently this configuration has been changing,
with Asian growth softening and Europe looking firmer.
The US has achieved fairly steady growth throughout
the period.

Labour market slack remains in some areas of the global
economy, especially in parts of Europe.

Global debt levels remain high.

And the recovery has been marked by periodic bouts of
nervousness in financial markets, including the one
we are seeing just now. I will have more to say about
that later.

One general indicator that things are still some way
short of normality is the level of global interest rates,
which are still at exceptionally low levels to support
growth. This remains the case notwithstanding the much-heralded
rise in the US Federal funds rate at the end of last
year.

An obvious question that arises from all of this is
why has the recovery from the deep recession of 2008
and 2009 been so protracted? I suggest that there are
two important factors at work here.

The first factor is that the GFC period involved more
than one crisis. It began in the US mortgage market
in 2007 and spread through various channels of contagion
to banks and financial institutions in other parts of
the world, especially the euro area and the UK. That
was the initial crisis, triggered by poor asset quality
and excessive leverage.

But even as the US was recovering from that, a second
crisis was developing in Europe. This was a crisis of
confidence in the sustainability of the euro as a single
currency area. At different times a number of the weaker
economies in the area have come under scrutiny as to
whether they would be able to meet their obligations,
with concerns particularly focused on Greece in key
periods. These episodes led to strains in financial
markets and increases in risk pricing, and they weighed
heavily on confidence and on the pace of recovery. With
the euro area accounting for just under one sixth of
the global economy, this in turn acted as a significant
drag on global growth.

The second factor is that, other things equal, history
suggests that recoveries from financial crises typically
take longer than those from other types of business
cycle events. It takes time to repair balance sheets,
to reduce excessive leverage and to unwind the asset
market imbalances that might be left behind by a crisis;
and it takes time to reverse the damage to trust and
confidence. One important recent study[2] found that the average duration
of impact from financial crises across a range of countries
over the past two centuries has been around five years.
Since this current episode has been more severe than
most, it is not surprising that its after-effects have
lasted even longer.

An exacerbating factor, too, has been the international
dimension. When a financial or a banking crisis occurs
in a single economy, or in a relatively small number
of countries, exchange rate depreciation is often part
of the market response and part of the recovery mechanism.
But there is obviously much less scope for that mechanism
to work when a crisis affects large parts of the global
economy simultaneously.

Taken together I think these factors go a long way towards
explaining the drawn-out nature of the global recovery
to date – even though, as I said, economic conditions
in recent times have been much better than they were
a few years ago.

Policymakers around the world have been responding to
this situation on a number of fronts. Interest rates
were reduced to near zero (or even slightly below zero)
in many advanced economies to support recovery and assist
in balance sheet repair, and they remain very low. In
Europe, significant institutional reforms are being
made to strengthen the stability of the euro area; these
are aimed at getting banking and crisis-management arrangements
across the area to function in a more unified way that
makes them more robust to shocks in the future. And
globally, there is an extensive program of reform underway,
for example in banking and securities regulation, to
build resilience in our financial systems. Australia
has been very much a part of that process.

A related development in this period is that there has
been a renewed interest in more proactive approaches
to the management of systemic risk. Partly this reflected
the lesson from the GFC itself that financial crises
are costly, and hence that there is a strong need for
better risk management. In keeping with that, institutional
arrangements have been strengthened in some jurisdictions
to support more proactive risk management by supervisors,
where that was found to be lacking. A related point
is that, in a low interest rate environment, supervisors
have seen a need to be particularly vigilant against
a build-up of risk in interest-sensitive sectors. A
number of them have been taking measures in recent times
to respond to developing risks, often focused on property
lending. I will have more to say about that later.

To summarise (and oversimplify) this picture somewhat,
the after-effects of the GFC on the global economy have
included:

an extended period of low interest rates

‘search for yield’ behaviour by investors
in some interest-sensitive sectors, and

a strengthened focus on risk management by prudential
supervisors.

Recent developments

With all of that as background, I want to turn now to
more recent developments.

It is useful to take that in three parts, namely the
global risk environment, possible implications of that
environment for Australia, and domestically generated
sources of risk.

The global risk environment

Prior to the current bout of market volatility, our
most recent Financial Stability Review, published
late last year, noted an improvement in conditions in
Europe and a general shift in the focus of risk towards
emerging economies.

In Europe this trend seemed to reflect, at least in
part, a greater degree of confidence in Europe-wide
institutions. The European authorities have taken a
number of actions over recent years to alleviate financial
system risks, including increased support from the ECB
and ongoing progress in unifying the system of banking
regulation.

More generally, the condition of the European financial
sector has been gradually improving in a number of respects.
Non-performing loans of European banks are still high,
but they have been falling for two years mainly in some
of the periphery countries (Graph 1). Bank profitability
has picked up a bit and banks are now better capitalised.
And stronger balance sheets have enabled banks in the
euro area to make some gradual increases in their lending
to businesses and households. All of that said, there
remain significant uncertainties in the euro area and
some of the earlier concerns have resurfaced in the
recent market turmoil.

Graph 1

At the same time, our Review noted that financial
stability risks in China have been building. The Chinese
economic expansion over recent years has been associated
with increasing debt, strong asset price growth and
apparent overinvestment in some sectors and regions
(Graph 2). If growth were to fall further from
its high recent rates, past excesses might be exposed,
and leverage is always harder to manage in a slower
growth environment. These risks of course are hard to
assess. The Chinese authorities have many levers to
support growth and financial stability, given the ongoing
large role of the state in the economy, the heavily
regulated financial system and the presence of capital
account controls. The measured central government fiscal
position is also strong, though the overall public sector
position is less so given the build-up in debt among
local governments and state-owned enterprises.

Graph 2

Outside China, country-specific risks also seem to have
been increasing in a number of other emerging market
economies – for example Brazil, Russia and Turkey. Among
the various factors contributing to that have been falling
commodity prices, political instability and concerns
over excessive corporate leverage. In response, equity
prices and exchange rates in these economies have generally
fallen quite sharply. These trends were already evident
through the course of last year.

These factors form part of the background to the nervousness
seen in a number of markets in the early part of 2016.
As I said at the outset, the early part of this year
has seen some significant volatility in global markets,
especially in equities and in some commodity prices.
There has also been some widening in risk spreads for
lower rated corporates and emerging market sovereigns.
The broad equity price indices have fallen by around
10 per cent in the United States, 15 per cent
in Europe, and by around 20 per cent in China since
the start of the year (Graph 3). These have been accompanied
by further large falls in prices of some commodities,
most notably oil, continuing the declines that they
had recorded over the previous couple of years (Graph
4).

Graph 3

Graph 4

From a financial stability perspective, these developments
raise a number of important questions: to what extent
(if any) are these price movements inter-related, and
in what way? And what, if anything, do they tell us
about the evolving risk environment?

It is in the nature of these things that definitive
interpretations are rarely possible, and certainly not
in real time. At this stage a number of possible hypotheses
might be put forward:

the combination of lower equity and commodity prices
might be signaling a weaker global outlook;

it might simply be an indication that equity markets
had previously been overvalued and in need of a correction;
or

the equity price falls might in part be an irrational
response to commodity price falls and other economic
data, or at least contain an element of overreaction
to genuine signals.

Most likely there is an element of validity in more
than one of these, and no doubt other hypotheses can
be put forward as well. As I said, I don't think
it is possible to be definitive about these things,
but it is relevant to note that market and media commentary
often errs on the side of being unjustifiably gloomy.
A few points can be made on that score:

First, as always, the recent equity price movements
have to be put in perspective. This is not the first
bout of nervousness in these markets: in the advanced
economies there was a similar one late last year, from
which markets subsequently recovered, and the recent
declines reverse only a small part of the cumulative
gains during the post-crisis recovery period.

Second, there seems to have been relatively little new
economic data in the early part of this year to trigger
a significant reassessment of the global outlook. And
even though the Chinese economy has been slowing, it
is still growing at a reasonable rate.

Third, the hypothesis that falling equity and falling
oil prices are inter-related responses to a weakening
in global demand is hard to sustain. The falls in oil
prices seem to be mainly driven by strong supply, not
weak demand, as indeed has been the case for a number
of other commodities such as iron ore. Consistent with
that, other non-energy commodity prices have been relatively
stable during this recent period when oil prices have
continued to fall. This has important implications for
the general outlook. While an oil supply expansion could
be expected to have a range of complicated effects on
producers, consumers and holders of energy assets, it
would normally be considered a net positive for the
world as a whole.

I think these points argue against putting an excessive
focus on recent market movements. But, that said, there
has clearly been an increase in market volatility around
the word in recent times and a heightened focus on financial
risks.

Implications of the global risk environment
for Australia

At this point it is useful to ask how these international
sources of risk might affect the Australian financial
system.

Direct exposures of Australian banking institutions
to the risk factors I have been describing are quite
limited (Table 1). Exposures to the euro area have
been scaled back in the wake of the crisis and now represent
only around 1 to 2 per cent of Australian banks' consolidated
global assets. Although exposures to the Asian region
have been growing quite rapidly over recent years, they
are still a relatively small share of consolidated assets
– around 4 per cent. Many of these exposures are shorter-term
and trade-related, factors that should lessen credit
and funding risks. That said, operational and legal
risks around these exposures could be relatively high,
particularly given the rapid expansion of these activities
in recent times.

Table 1: Australian Banks' International Exposures

Ultimate risk basis, September 2015

Value

Share of international exposures

Share of global consolidated assets

$ billion

Per cent

Per cent

New Zealand

330

34

8

Asia(a)

177

19

4

– China

46

5

1

United Kingdom

177

19

4

United States

139

15

3

Europe

66

7

2

– Greece

0

0

0

Other

67

7

2

Total

957

100

24

(a) Asia includes offshore centres Hong Kong and Singapore

Sources: APRA; RBA

As a more general observation, Australian banks have
increased their resilience over recent years in a number
of respects, responding both to market expectations
and to regulatory and supervisory actions. Notably they
have raised capital ratios and shifted their funding
structures to make them more resilient to financial
market disruptions. Of course, none of this guarantees
that Australian banks will be immune to international
shocks in the future. But it suggests that the main
effects from the risks I've been describing are likely
to be indirect, working through the impact of factors
like commodity prices, trade flows, and confidence,
on the broader economy.

Domestically generated sources of risk

That brings me to the third part of our risk assessment,
namely domestically generated sources of risk. Here
our analysis has for some time focused on the buoyancy
seen in parts of the property market and the leverage
associated with that. Much of the focus has been on
residential property, and I will start with that before
turning to the commercial sector, where risks have also
been growing.

While the housing market has not been universally strong
around the country, we have seen a period of significant
strength in the Sydney and Melbourne markets in recent
times, with investors playing a large role. We are now
seeing some easing in these pressures, as I will describe
in a moment. But to summarise a few of the key facts:

Housing prices in Sydney reached a peak annual rate
of increase of 18 per cent in mid-2015.

In Melbourne the peak rate of increase was 14 per cent
around the same time.

The value of loan approvals to investors in New South
Wales approximately doubled over the two years to mid-2015.

Largely as a result of these developments, the household
debt ratio has been edging up again from a level that
was already high, at around 1&frac12 times annual income (Graph 5).

Graph 5

It is against this background that the Reserve Bank
has highlighted the need for prudence, and has supported
APRA and ASIC in the various measures that they have
taken over the past few years to strengthen lending
standards.

As a general proposition, mortgage lending standards
in the post-crisis period have been tighter, at least
more so than before the crisis. Low-doc loans are rare,
genuine savings are required to fund at least part of
the deposit, and the application of interest rate buffers
in serviceability assessments has become widespread.
Nonetheless, investigations by APRA and ASIC during
2015 showed that there had been some slipping in lending
standards and that they were inadequate in some important
respects to the current risk environment. Specifically,
APRA found that, in some instances, lenders' serviceability
assessments were based on over-optimistic judgments
about the reliability of borrowers' incomes, or
inadequate estimates of borrowers' living expenses,
or that they failed to take into account the possible
effect of future interest rate movements on a borrower's
existing debt commitments. ASIC's review of interest-only
lending practices made similar findings, and also noted
instances where the lender did not make reasonable inquiries
as to whether the loan product provided was suitable
to the borrowers' circumstances.

Furthermore, as a result of the additional scrutiny
over the past year and substantial data revisions made
by the banks, we now know that the level of investor
activity in the housing market was in fact higher than
previously thought. As we have highlighted in recent Reviews, a high level of investor activity
can add to the level of financial risks associated with
residential markets.

As you know, APRA announced a number of supervisory
measures in December 2014 to strengthen mortgage lending
standards. These measures included expectations that:

banks should not be increasing their share of higher
risk lending

growth in investor lending should not be materially
above 10 per cent

appropriate interest rate floors and buffers should
be applied in serviceability assessments.

In response, lending standards tightened significantly
over 2015. Interest rate buffers and floors were increased
at many banks and they are now much more uniform across
the sector. The level of higher risk lending has declined,
notably lending with an LVR greater than 90 per cent.
And the pace of investor lending growth has slowed significantly
in response to a wide range of price and non-price actions
that have been taken by the banks (Graph 6). This has
been a welcome development given the general maturing
of the current housing cycle.

Graph 6

The second main area of risk focus domestically has
been in commercial property. Historically this sector
has been a common source of financial instability both
here and abroad. During the height of the GFC, Australian
banks remained in comparatively good shape but they
did suffer a noticeable deterioration in asset performance,
with the aggregate non-performance rate rising to just
under 2 per cent of loans. A significant part of that
deterioration was in their commercial property lending;
impaired commercial property exposures accounted for
around 30 per cent of Australian banks' non-performing
domestic assets at that time.

After the post-crisis downturn, the commercial property
sector is again experiencing strong investor demand,
and bank lending to the sector is increasing. However,
there are a number of emerging signs of increasing risk.
Trends in commercial property prices and rents have
been diverging over the past few years, with prices
continuing to rise while rents have been flat to down
(Graph 7). As a result, yields have declined. At
the same time, vacancy rates have been increasing.

Graph 7

As in the housing market, conditions have not been uniform
across the country, and they have been noticeably firmer
in Sydney and Melbourne than in other cities. But the
major commercial property markets have all seen downward
pressure on yields over recent years. Strong demand
from foreign buyers has contributed to this, reflecting
the global environment of low interest rates and ‘search
for yield’. The risks appear manageable at this
stage, but they underscore the need for sound lending
practices and for appropriate prudence by investors.

Concluding comments

In summing up, and to return to my original theme, the
Reserve Bank has a longstanding mandate for financial
stability, affirmed for example as part of the Wallis
reforms in 1998. In the post-Wallis world, this has
not been primarily a regulatory function. The Bank does
have regulatory powers in some areas relating to financial
stability, notably in its oversight of payments systems
and financial market infrastructures. But the financial
stability function goes well beyond that to the Reserve
Bank's wider role in the financial system. It includes
the Bank's role as the liquidity manager for the system
and as the provider and operator of core payments infrastructure.
It also includes coordination with other regulators.
At a formal level, this is done through the Bank's role
in chairing the Council of Financial Regulators, but
there are numerous less formal channels of coordination
and sharing of information and analysis. These arrangements
were reviewed and supported most recently in the Murray
Inquiry.

One important component of this financial stability
work is the provision of timely risk analysis, to help
inform the policy debate and also to help inform the
decisions of lenders and investors. I have given a summary
of our latest analysis today, and I hope you will find
that helpful in informing your own investment decisions.

With that, I thank you for your attention, and wish
you every success.

Endnotes

This is an expanded and updated version of a speech presented in November 2015.
Malcom E (2015), ‘The Risk Environment and the Property Sector’, Speech at the Australian
Property Institute's Queensland Property Conference, Gold Coast, 6 November.
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